In a divorce, when either or both spouses own a closely held business, the dissolution of the marriage becomes more complex. There are several questions to consider: Should the couple sell the business and split the proceeds? Should one spouse keep the business and give half of the value to the other — or offset other assets? Should the couple keep owning the business together after the divorce?

No matter what is decided, a business valuation is generally obtained. (In a contested divorce, both spouses may obtain separate valuations.) This process is complex and involves a professional business appraiser, who potentially could serve as an expert witness.

Valuing a business or a business interest in a divorce has become one of the most common reasons for obtaining a business valuation. It has also generated more than its share of reported court decisions. In part, this is due to the myriad of laws and case law in various states and jurisdictions of the United States.

Making sense of this patchwork quilt can be difficult. This article describes some issues that should be considered in obtaining a valuation for a marital dissolution.

State Law Specific

In some ways, divorce valuation is still the Wild West of valuation services. As noted, since the cases are not heard in federal courts, they are subject to the rules, law, and case law of particular states or jurisdictions. It should also be noted that family law courts are courts of equity. The judge might determine a value for a business interest based on the needs of splitting the entire marital estate and not specifically on the value determined by one or the other of the experts.

The rules are complex and depend not just on state law, but on whether the business is a sole proprietorship, partnership, S corporation, C corporation or LLC.

So it is important for the attorney and a valuation expert to agree on some concepts up front so they know which direction to go:

• What is the appropriate standard of value for the jurisdiction in which the case is being tried?
• How is personal goodwill handled in the jurisdiction? Personal goodwill is directly tied to the person operating or working in the business. If he or she left, how would the business be affected?
• What type of report is best for the case at hand?
• What other unique issues regarding how a business is to be valued exist in the jurisdiction?

Here are some examples:

• Florida has an “active participation” rule, which requires the owner of the business to actively participate in it in order to have the full value included in the marital estate.
• Some jurisdictions do not allow the inclusion of inherited property in the marital estate. (Note:A judge may be able to use the “court of equity” concept to “back door” the value of inherited property).
• Although it is rare, a state may eliminate personal goodwill from professional practices (but still allow enterprise goodwill, which is attached to the business rather than an individual).
• Some states make the assumption that the value is determined as if the business is NOT being sold.
• Some states do not allow “tax affecting” for pass-through entities. Tax affecting involves a business valuator making adjustments to future earnings on the basis of assumed future tax bills. It generally comes into play when the value of an S corporation is discounted to take into account the tax rate applicable to C corporations.

Because of the uniqueness of the particular jurisdiction in which the divorce proceeding resides, it is also important that the report provided by the business valuation expert include the type of information that is helpful to the judge in determining the resulting value. That information assists the judge in determining the rationale for the expert’s conclusion of value. It also provides a clear record for appeal.

For example, let’s say a business that has two primary segments — one devoted to a single large multi-year government contract and the other to serving small businesses with similar products. If the appraiser knows that the government contract is ending and will not be renewed, he or she will obviously take that into account in developing the future business income to be valued. Without additional explanation in the report, the court might miss the circumstances of the government contract ending and wonder why the appraiser has developed a lower value for the business.

The standard of value is also important in a divorce case. A standard of value relates to the type of value being utilized in a specific engagement. Many states claim to have a fair market value standard in divorce cases.

The definition of fair market value is the price, expressed in terms of cash equivalents, at which property would change hands between a hypothetical willing and able buyer and a hypothetical willing and able seller. Both parties must be acting at arm’s-length in an open and unrestricted market, when neither is under compulsion to buy or sell and when both have reasonable knowledge of the relevant facts.

But be careful not to be fooled by what the supposed standard of value is. Often fair market value would better be referred to as “fair market value except.” For example a particular state or jurisdiction might exclude transferrable personal goodwill, might not allow tax affecting in determining the income approach value, and might require that a hypothetical sale of the business not be taken into account.

This last point often manifests itself in a “value to the holder” premise. This considers the value of a business or business interest in the hands of its owner, regardless of whether he or she intends to sell the business. It further assumes that the titled spouse will continue to enjoy the benefits generated by a business that was created or appreciated during the marriage.

There are many other issues that arise in the area of divorce valuation, but the important point is for the attorney and the appraiser/ valuation expert to be knowledgeable about the important issues for the jurisdiction where the matter is being heard. Together, our team can provide the best possible result for you.